ETF Risks in Perspective: Synthetic ETFs

Not so long ago, ETFs were simple and transparent. But with the tremendous growth in the industry, ETFs have not only become more numerous, but also more complex and opaque. A number of influential bodies—including the International Monetary Fund, the Financial Stability Board, and the US Senate—have expressed concerns about how ETFs might damage the global financial markets. As a Canadian ETF investor, should you be worried about the funds in your portfolio?

In a series of three posts, I’ll take a look at the major concerns and try to give some perspective, with a specific focus on Canadian ETFs. Let’s kick off with a look at the new breed of “synthetic ETFs.”

The problem

Synthetic ETFs use a derivative called a total return swap to get exposure to the indexes they track. The ETF provider enters into a deal with a counterparty (usually a bank) who agrees to deliver the precise return of the index, minus a fee. While the swap structure has many potential benefits—including lower cost, smaller tracking error, and tax efficiency—it also introduces counterparty risk. If the bank fails to deliver the promised returns of the index, investors in the ETF may suffer losses.

To mitigate this risk, regulators require the counterparty to post collateral. If the counterparty were to default on its obligation, the ETF provider would have a claim to the collateral, and investors who redeem their shares should receive full market value. But there are several potential problems:

• The bank’s collateral may be assets that are illiquid or of low quality. If the ETF provider has to sell this collateral in order to redeem shares during a period of financial turmoil, it may be unable to do so.

• Some of Europe’s biggest providers of swap-based ETFs are banks (such as Deutsche Bank and Société Générale), and their counterparties may be the asset-management arms of those same banks. There are potential conflicts of interest here: for example, a bank may find it convenient to use its most illiquid assets as a basket of collateral for one of its own ETFs.

• At least half of all European ETF assets are now in synthetic products, and all of that counterparty exposure may create a systemic risk. If all of the banks have derivative agreements with one another, one counterparty failure could trigger a domino effect, as it did during the mortgage meltdown.

What Canadians need to know

Despite their popularity overseas, there are only two swap-based ETFs in Canada: Horizons S&P/TSX 60 (HXT) and Horizons S&P 500 (HXS), both of which use the National Bank of Canada as the counterparty. With the above risks in mind, consider the following:

• While it is certainly possible that a major Canadian bank could become bankrupt, most people would consider that risk remote. If you would buy stock in National Bank, you should feel comfortable buying an ETF backed by the bank’s credit.

• Horizons and National Bank are not unaffiliated: National Bank Financial owns 20% of AlphaPro Management, a division of Jovian Capital, Horizons’ parent company. Clearly all the parties have an incentive to monitor each other’s financial health to protect their interests, but investors should be aware of the relationship. Ideally an ETF provider should use more than one counterparty to spread out the risk, and Horizons has said it plans to do this when the ETFs grow large enough.

• Under Canadian mutual fund regulations, counterparty exposure cannot exceed 10% of a fund’s assets. This means that even if the counterparty did fail, the worst-case scenario is that an investor would recover 90% of the index’s current value.

• The collateral provided to Horizons consists of high-quality, liquid money market instruments. In the unlikely event of a counterparty default, there should be no difficulty in selling this collateral to redeem the shares of the ETF.

• Horizons’ two swap-based ETFs have a total of just $325 million in assets, less than 1% of the Canadian ETF market share. If there is any concern about the overall counterparty risk in the Canadian financial markets, ETFs are a drop in the ocean.

If you’re interested in learning more about how synthetic ETFs works, Horizons has produced a clearly written educational report. But if you’re intimidated by the whole idea, or if you think they’re too risky, then don’t use HXT or HXS in your portfolio. Stick to traditional ETFs that hold the stocks in the index directly, such as the iShares S&P/TSX 60 (XIU) and the iShares S&P 500  (XSP). It’s as simple as that.

The concerns about synthetic ETFs are legitimate, but they are mostly problems for European regulators to sort out. Unfortunately, if there is a financial crisis triggered by synthetic ETFs overseas, you will be affected no matter what you hold in your portfolio. Let’s hope the regulators do their jobs effectively.